Topics: Risk and Uncertainty Attitude Towards Risk and Uncerainty The Demand for Insurance and Risky

Assets

Choice under uncertainty Uncertainty in a pervasive feature of the economic life. Many events and outcomes of actions are random: may or may not occur (good or bad weather for the agriculture), or may take dierent values (prices, incomes). Main questions: (1) How to describe uncertainty? (2) How the economic actors i.e. rms and individuals take the decisions under uncertainty? (3) How to describe preferences over random events? (4) What is the eect of uncertainty on the individuals, on their utility (welfare) and their choices? (5) What is the eect of risk?
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Probability and Probability Distribution. States of the World First task: develop a common language to deal with dierent types of uncertainty and describe them in a universal way. The most convenient description of the random events can be given by using the following concepts: (i) random variable (ii) the state of the world (iii) probability distribution random variable is a common name for the thing that we are studying (weather, price, income) and the value of which is random (uncertain) and will be realized in the future. A random variable is synonymous with uncertainty.
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Denition. A possible realization (outcome) of a random variable is called a state of the world. For example, if prices tomorrow can take integer values from 1 to 10, then there are 10 possible states of the world tomorrow each corresponding to a dierent price. When price turns out to be equal to pi, we say that the state of the world corresponding to p = pi has occurred.

 Suppose that the variable x which we are studying (next years crop, your starting salary after graduation, the loss or win in the casino) is uncertain can take n possible values xi i = 1, ..., n. Let i be the probability that outcome xi occurs. Note that i 0 and i=n = 1. Then { , , .., } is called n 1 2 i=1 i the probability distribution. It describes how the probabilities with which possible values of x are distributed. Often, we will write (.) as a function of the realization of x. Interpretation: the probability that the variable x takes value xi is given by (xi) = i

 Consider some random variable x. Suppose that we know that it has possible realizations xi, i = 1, ..., n, and corresponding probabilities i. (i.e. we know its probability distribution). Main characteristics of a random variable are expected value and variance. Expected value (synonymous with average value):

i=n

E (x) =
i=1

ixi

Variance of the random variable:

i=n

V ar.(x) =
i=1

i (xi E (x))2
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Variance and Standard Deviations

Standard deviation and variance are measures of risk
Measure how variable the outcome will be More variability means more risk Individuals generally prefer less variability less risk

Variance An Example
Suppose you are choosing between two part-time sales jobs that have the same expected income ($1,500) The first job is based entirely on commission The second is a salaried position

Variance An Example
There are two equally likely outcomes in the first job: $2,000 for a good sales job and $1,000 for a modestly successful one The second pays $1,510 most of the time (.99 probability), but you will earn $510 if the company goes out of business (.01 probability)

Variance An Example
Outcome 1 Prob. Job 1: Commission Job 2: Fixed Salary .5 .99 Income 2000 1510 Outcome 2 Prob. .5 .01 Income 1000 510

Variability An Example
Income from Possible Sales Job Job 1 Expected Income

E(X1 ) = .5($2000) + .5($1000) = $1500

Job 2 Expected Income

E(X2 ) = .99($1510) + .01($510) = $1500

Variance
While the expected values are the same in these two jobs, the variances are not equal Greater variance signals greater risk Variance comes from deviations in payoffs from the mean

Variance and Standard Deviation An Example

Deviations from Expected Income ($)
Outcome Deviation Outcome Deviation 1 2

Job 1 Job 2

$2000 1510

$500 10

$1000 510

-$500 -900

Standard Deviation Example 1

Standard deviations of the two jobs are:
= Pr1 [X 1 E ( X )]2 + Pr2 [X 2 E ( X )]2
1 = 0.5($250,000) + 0.5($250,000) 1 = 250,000 = 500
2 = 0 .99 ($ 100 ) + 0 .01($ 980 ,100 ) 2 = 9,900 = 99 .50

Standard Deviation Example 1

Job 1 has a larger standard deviation and therefore it is the riskier alternative The standard deviation also can be used when there are many outcomes instead of only two

Preferences Toward Risk

Will an individual prefer a more risky or less risky alternative? How will she trade off risk versus expected value? How will she behave under uncertainty?

Main issue: the eect of uncertainty on an individual consumer. Question 1. Does uncertainty lower or raise the consumers utility? Question 2. How does an individual consumer perceive risk? Would she like to avoid or face more uncertainty? Uncertainty is synonymous with risk. Therefore this question is about attitude towards risk. Is more uncertainty in income better or worse for a consumer? Question 3. How does a consumer take decisions under uncertainty about the consequences of the decision and payos from it? Question 4. Demand for insurance. How much is an individual is willing to pay for insurance?
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Expected utility approach- Evaluating the uncertainty according to the expected utility of the outcome. Suppose that income is uncertain. In our terminology, income x is a random variable with probability distribution described by: (1, ..., n). The individual possesses utility function u(.) which measures the utility of money (obtained from regular utility function by substituting the demands into it). Then she will evaluate this random income according to the expected utility function:
i=n

EU (x) =
i=1

iu(xi)

So, an individual will prefer income x (random variable) to income y (random variable) if and only if: EU (x) > EU (y )
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Utility of wealth (income) function u(I ) is not the same as the consumption utility function that we have seen before, but is related. (It is sometimes called indirect utility function.) Its existence follows from similar axioms as the existence of the utility of consumption function. The properties of u(.) determine how an individuals views uncertainty and likes or dislikes risks. Intuition on the relation between the consumption utility function which we have studied and the wealth utility function: Suppose that the individual has a regular utility function u (x1, ..., xn). Derive the demands x1(p1, ..., p n , I ), ..., xn (p1, ..., pn and insert them into the individuals utility function to obtain indirect utility function
u(p1 , ., , , pn , I ) u (x 1 (p1 , ..., pn , I ), ..., xn (p1 , ..., pn , I ), I ).

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If income could either be high WH with probability H or low WL with probability L, then the expected utility of this individual would be: H u(p1, ., , , pn, WH ) + Lu(p1, ., , , pn, WL)

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Attitude towards risk and uncertainty How to identify whether a person likes or dislikes risk and uncertainty? Random variable describing income x is also referred to as a lottery. A fair lottery x: expected value of income is equal to zero. i.e.
i=n

E (x) =
i=1

ixi = 0

Denitions A consume is risk-averse if she prefers to obtain the expected value of the lottery for sure rather than to face the lottery:
i=n

EU (x) =
i=1

iu(xi) < U (Ex)

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 Risk-neutral consumer: indierent between playing and not playing a lottery. i.e.
i=n

EU (x) =
i=1

iu(xi) = U (Ex)

Risk-loving consumer: prefers to face the lottery rather to obtain its expected value, i.e.
i=n

EU (x) =
i=1

iu(xi) > U (Ex)

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 The properties of u(W ) determine whether the consumer is risk-averse, risk-neutral or risk-loving. For risk-averse consumer, u(W ) must be concave. Risk-neutral buyers: u(W ) is linear. Risk-loving consumer: u(W ) is convex.

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Risk Averse Utility Function

Utility 18 16 14 C F D
The consumer is risk averse because she would prefer a certain income of $20,000 to an uncertain expected income = $20,000

A 10

10

16 20

30

Income ($1,000)

Preferences Toward Risk

A person is said to be risk neutral if they show no preference between a certain income, and an uncertain income with the same expected value Constant marginal utility of income

Risk Neutral
Utility 18
E

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The consumer is risk neutral and is indifferent between certain events and uncertain events with the same expected income.

10

20

30

Income ($1,000)

Preferences Toward Risk

A person is said to be risk loving if they show a preference toward an uncertain income over a certain income with the same expected value
Examples: Gambling, some criminal activities

Increasing marginal utility of income

Risk Loving
Utility 18 E
The consumer is risk loving because she would prefer the gamble to a certain income.

10.5 8 A 3 0 10

F C

20

30

Income ($1,000)

Attitude towards risk and demand for insurance Buying Insurance allows a consumer to (partially) reduce or eliminate risk in exchange for a payment of a premium. A good way to evaluate whether the consumer likes or dislikes uncertainty is to examine whether she has demand for insurance or not. Issues: (1)What should be the price of insurance: from the consumers and the insurers point. (2) Demand: How mush insurance will an individual purchase?
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Insurance With probability G no accident happens (good state of the world) and consumer preserves her full wealth WG. However, with probability B = 1 G a consumer with income has an accident (hurricane, etc.) and sustains a loss that drives her income down to WB < WG (bad state of the world). Her expected utility is: Gu(WG) + B u(WB ). The consumer can purchase insurance at price p per dollar of coverage for the case of an accident. If she purchases insurance policy worth x dollars, she pays p x in each state of the world and would get x dollars from the insurance company in the bad state of the world only. Insurance is actuarilly fair if the price of insurance for a certain state of the world is equal to the probability of a loss on that state of the world, i.e. p = B .
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How mush insurance would she purchase? To answer this question, solve the following problem: max Gu(WG px) + B u(WB px + x)
x

Dierentiate this with respect to x to get the rst-order condition: Gu (WGpx)(p)+B u (WB px+x)(1p) = 0 Rearrange to get the following condition C : u (WB px + x) p 1 B = u (WG px) 1 p B

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First, consider concave functions u(w) i.e. u (w) < 0. Then the solution (optimal x) to the above equation has the following properties: Result 1. If p = B (actuarily fair insurance) then: x = WG WB . This means that a consumer buys full insurance and fully insures in the case of risk, i.e. her income in each state of the world would be WGG + WB B Result 2. If p > B (actuarily non-fair insurance), then from condition C we have: u (WB px + x) > u (WG px) Therefore, since u(W ) is concave, WB px + x < WG px i.e. x < WB WG. That is, the person will not buy full insurance, but would normally buy some insurance, i.e. x > 0 provided that the price p is not too high compared to B .
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To convince yourself that the individual will still buy some insurance, consider u(W ) = log (W ) which has the derivative 1 . Then our rst-order condition U (W ) = W C becomes: WG px p 1 B = WB + x px 1 p B Suppose that WG = 3, WB = 1, p = 0.2, B = 0.1 Putting these numbers in, we get: 3 0.2x = (1 + 0.8x)2.25 which can be solved to give: 1.6x = 0.75 or x = 15/32 < WG WB = 2. This insurance is less than actuarily fair, so the consumer insures only partially.

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If u(W ) is linear u(W ) = a + bW , then the person is risk-neutral and cares only about the expected value of income. Her insurance choice problem is: max Gu(WG px) + B u(WB px + x)
x

can be rewritten as: max G (a + b (WG px)) x + B (a + b (WB px + x)) = max a + b (GWG + B WB )
x

+ xb (B (1 p) Gp) Using G = 1 B , it is easy to nd the optimal x that maximizes this expression: If B > p then x is innite: the person want to buy a lot of insurance. If B (1 p) (1 B )p = 0 i.e. B = p then any x is optimal: the person does not care whether to buy insurance or not.
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If B (1 p) (1 B )p < 0 i.e. B < p then x = 0: the person does want to buy any insurance. Conclusion: under risk-neutrality the consumer engages in arbitrage. She will buy an innite amount of insurance if it is better than fair, i.e. if B > p. She is indierent how much to purchase if B = p.

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 Now suppose that u is convex, i.e. u (W ) > 0. Then the person will not buy any insurance i.e. x = 0. This individual strictly prefers not to buy any insurance. (S)he likes risk. Would prefer to gamble as in Las Vegas. Example: u(W ) = W 2. The consumers problem of maximizing the expected utility EU is: max EU = G(WG px)2 + B (WB px + x)2 x Dierentiate this with respect to x: dEU = 2G(WGpx)(p)+2(B WB px+x)(1p) dx

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This is equal to: dEU = dx 2GpWG+2B (1p)WB +2x p2G + (1 p)2B Dierentiate this once again to get: dEU 2 2 + (1 p)2 = 2 p G B >0 dx2 Since the second-order derivative is positive, the optimal solution is at the corner, i.e. x is either minimal i.e. x = 0, or maximal px = WG (spend all income WG on the purchase of insurance). In any case, the consumer shifts all wealth to one state of the world and does not insure.

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Risk premium and Certainty Equivalent Consider a risk-averse consumer with concave utility of income/wealth function u(.). This consumer faces uncertainty: she which takes value has a random income W Wi with probability i. Her expected utility is )= Eu(W
i=n

u(Wi)i
i=1

= W . Note that Expected income is E W =W +x we can write: W where x is a fair lottery i.e. E x = 0. Then: ) = Eu(W +x Eu(W ) =
i=n i=1

+ xi)i u(W

The consumer would prefer to get the expected utility of W for sure, in which case her nal utility in this case would be u(EW ): Eu(W ) < u(EW ). She would get u(EW ) if actuarily fair insurance was available.
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Risk Premium and Certainty Equivalent. This individual would be willing to pay a fee to avoid facing the uncertainty, i.e. for the right to purchase actuarily fair insurance. The maximal fee F that she is willing to pay is s.t. ) = u(E W F) Eu(W F solving this equation is called the riskpremium. It should be clear that F > 0 for risk-averse individuals. Denition: Risk-Premium -the amount of money that an individual is willing to pay to avoid uncertainty of income and get the expected value of income for sure. Risk premium depends on the properties of uncertainty and on the utility function. The higher is risk premium the more risk-averse as an individual.
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Risk-premium. ) > u(E W ). For risk-loving individual, Eu(W The risk-premium is F s.t. ) = u(E W F ). Clearly, for such inEu(W dividual F < 0. So risk-loving or risk-neutral parties should provide actuarilly fair insurance to more riskaverse parties in exchange for a fee. This would improve the eciency of the economy since everyone would become better o. This is called Pareto improvement. Another measure: is Certainty equivalent. Certainty equivalent is the level of wealth F. CE such that CE = E W
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Risk Premium and Coecients of Risk-Aversion

Let us apply Taylor series approximation to a fair lottery x :

i=n

F) = u(W
i=1 i=n

+ xi )i U (W
i =n

x2 )+ )xi i + ) i i + higher order terms u(W U (W U (W 2 i=1 i=1 1 1 ) + U (W ) u(W x2 = u ( W ) + U ( W ) V ar( x) i 2 i=1 i 2
i =n

F ) u(W ) F u (W ) At the same time u(W

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Thus we obtain: 1 u(W ) F u (W ) = u(W ) + U (W ) V ar( x) 2 ) V ar( x) U (W F = ) 2 U (W The coecient of absolute risk-aversion, or Arrow-Pratt coecient: ) U (W r A (W ) = . U (W ) It summarizes the eect of the shape of the utility function on the persons attitude towards risk. The coecient of absolute-risk-aversion ) typically changes with wealth W . r A (W ) decreases with wealth, then this If rA(W would imply that an individual becomes more tolerant towards risk as her/his wealth increases. Such individual would be buying more risky assets (stocks) as her wealth increases.
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 Another useful measure of attitude towards risk: ) U (W )= r R (W )W U (W is the coecient of relative risk-aversion.

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Conclusions. Main Principles of Insurance. Insurance is a shift of the risk from one party to another in exchange for a fee (insurance premium). In economic jargon, insurance is trading of risk. Less risk-averse party (e.g. risk-neutral) can provide the insurance, i.e. take more risk upon itself. More risk-averse party should purchase insurance and pass on the risk to a less riskaverse party. She is willing to pay up to the risk-premium. This insurance transaction (trading of risk) allows to increase the utility of each of them, so it is a Pareto improvement.
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